The Differences Between Islamic Banking and Conventional Banking System - Essay Example

Banking System Introduction The banking sector is an important part of the economic system in any country. Banks are major actors in the financialsystem, and their principle role is to direct funds from depositors to borrowers in a systematic manner. Banks provide different kinds of financial services, which act as guidance for customers to know about the opportunities for savings and borrowing. All these functions together contribute towards making the overall economy more efficient. The modern society cannot survive without the existence of banks. Banks are financial institutions that act as safe deposits of people’s savings without which they will have no place to save and will also face the risk of keeping all money at home. Banks also facilitate lending and people can borrow any amount of money they require in any convenient manner. Banks essentially act as intermediary between depositors who lend money to the band and borrowers to whom the banks lend money. The amount that banks pay to the depositors and the amount that they received from the borrowers are both called interest. Both depositors and borrowers can be individuals, families, organizations, governments and so on. Since at any point of time some depositors withdraw their money, many others do not. This provides the banks opportunity to convert short term deposits, which are their liabilities to long term loans which are their assets. The interests that banks pay to their borrowers are less than the interests that the banks pay to their depositors. This difference serves as income of banks all over the world. Although banks play a crucial role in the management of money from depositors and lending money to the needy, banks are also indispensable for national and international payments system. Banks also create money. Individuals, organizations or governments do not only need banks as safe custody of their money, but they all also need to circulate their funds like money getting transferred from “buyers to sellers or employers to employees or taxpayers to governments” (Gobat). In this case too banks play a prominent role. They handle payments like issuing personal cheques to making electronic payments of large amounts between banks. The payments system is a “complex network of local, national, and international banks and often involves government central banks and private clearing facilities that match up what banks owe each other” (Gobat). In today’s era of international trade, most payments are administered instantly. An efficiently managed system of payments is indispensable for a stable and growing economy, and any inefficiency in the payments system can hinder smooth trade and therefore can significantly hamper economic growth. The Islamic Banking system is based on the beliefs of Islam that says that God has endowed man with knowledge, power, talents and wisdom. In return God wants man to act in the manner that will help fellow beings. Based on this religious belief, Islamic banks serve the financial needs of billions of Muslims all over the world. Since payment of acceptance of interest goes against the law of Islam, therefore borrowers need to pay only the amount they have borrowed. The research question of this paper is “What is the difference between Islamic banking and conventional banking system? Considering the immense importance of banks in modern economy, it is necessary to understand the functioning of Islamic banking systems as it caters to billions of customers. Moreover, since the 2008 global economic crisis, Islamic banks are gaining more attention from economists and financial experts. This is because the strict regulations of Islamic banks and their reluctance to indulge in debt trading and speculations make them seem a better solution to the ongoing global crisis. Literature review Customer preference The Islamic banking system and the conventional banking system have completely different processes of functioning based on distinct principles. While the former functions following the principles of Shariah Law (Islamic law), the latter has a more non-conservative approach. For Islamic banking, lending money essentially means to enter into partnership business, while conventional banks lend money for the purpose of taking it back with full interest. In Islamic banking, the lender does not exert extreme pressures on borrowers to get back their money. However, although Islamic banks lend money without charging any interest, a minimum amount is charged while entering into an agreement with the borrower. The basic concept of conventional banking is lender and borrower relationship between both bank- depositor and bank -borrower. A study was conducted by Al-Tamimi et al. (2009) to explore the perspectives of UAE customers regarding Islamic banking and conventional banking. It was assessed that service efficiency and bank products are two important criteria for creating reputation of a bank. The study revealed that 70 percent of UAE customers prefer Islamic banking and the major reason is its products while those who prefer conventional banking do so for both products and services (Al-Tamimi, 239). The authors concluded that given the high percentages of customers preferring Islamic banking there is therefore huge potential for its development considering it improves its services. However, the study also revealed that customers do not hold any different perspectives regarding the two systems of banking which is surprising because of the different principles and functioning of the two banking systems. It was concluded that both types of banks should focus more on services like better responses to customer queries, sufficient cash available in cash machines, and efficient and cooperative staff. Another article by Alemu (2012) is based on a study conducted on 322 bank customers from three countries that have both kinds of banking systems like Bahrain, Jordan and UAE. Results show that the major factors that affects customers’ choice of Islamic banks includes gender element like Islamic banks provide separate service for women. The choice of conventional banks is dependent on other significant factors like “better rate of return, accessibility to credit, and SMS banking” (Alemu, 458). Other than products and services, there is a general view that customer’s choice of Islamic banks is more due to religious affiliations although there is no concrete evidence to support this theory. In the last three decades, Islamic banking has developed to become popular even among non-Muslim population in spite of its strategies based on Shariah Law. During the ongoing financial crisis, many banks in the Western countries have faced the brunt and collapsed, but Islamic banks have continued to develop in both prominence and size. The general consensus that Islamic banks are mostly favored by Muslims have been contradicted by reports which say that 40 percent of Islamic bank customers in Malaysia and non-Muslims while in UK the figure is 20 percent (Alemu, 445). The major difference between the two kinds of banking systems is the interest factor like the Islamic banks do not charge interests to borrowers, and for depositors there is profit sharing arrangement. Unlike in a capitalistic economy where interest rate remains fixed irrespective of the financial condition of the entrepreneur, under Islamic law interest is prohibited in any form. In capitalism, profit is more like reward for taking risk by entering into business, while from Islamic perspective anyone investing money into any venture should take the responsibility of profit or loss. The prohibition of interests under Islamic law means there is no money lending business, and also since investors are rewarded with profits rather than interests therefore they are encouraged to take active participation in the financial success of business (Alemu, 462-463). Islamic inter-bank money market In the 1980s, Islamic banking was introduced in Malaysia with a view to convert the financial activities of conventional banks to Islamic approach. Bacha (2008) in his article explored the money market operations of Islamic banking within a dual banking system. Although Islamic banks performance is based on interest free conditions, however many of the risks attached are similar to conventional money markets. In case of Islamic inter-bank money market (IIMM), interest rate fluctuations in conventional market get transmitted to Islamic banks when they use IIMM for liquidity management. Since prices of IIMM instruments are dependent on those of conventional money markets, therefore Islamic banks issuing IIMM instruments will incur more costs if interests rates in conventional markets increase. Similarly, if interest rates fall then investors of IIMM instruments will be getting reduced returns. Under no condition can Central Bank maintain dual interest rates for Islamic banks and conventional banks in a dual banking system. Customer services As already mentioned in earlier part of this section that services in Islamic banks do not hold much appreciation from customers’ perspective, therefore Chaker and Jabnoun (2010) have explored the hindrances to efficient services in Islamic banks which are flourishing more particularly in the Gulf region. For any banking institution, its services are measured on the basis of five dimensions which are reliability which measures the efficiency of staff performance, responsiveness which assesses how fast and efficiently the staff responses to customers’ queries, tangibility which means the physical facilities and the appearance of the staff, assurance which indicates the knowledge level of the staff and their ability to gain customers’ trust and confidence, and empathy which refers to the behavior of the staff and the attention they provide to individual customers. In the Arab countries, the power structure is such that those who are managers seek loyalty and compliance from those they manage, as well as they maintain social distance from the latter. This system indicates centralized decision making which means decisions are made by those who are far away from customers thus leading to insufficient responsiveness to the public and lack of study of customer interests. This is a major obstacle to efficient customer service since “understanding the determinants of customer loyalty will allow management to concentrate on the major influencing factors that lead to customer retention” (Chi & Qu, 625). Moreover, the executive level people act under rigid environment thereby giving minimum opportunities to first line employees to make any kind of decisions. This discourages the employees to take any kind of approaches on behalf of the customers. Since there is lack of empowerment in the hands of first line employees, they are inhibited to support customers’ views and therefore they find it more convenient and safer to say no to customers. The situation becomes grave more because managerial recruitments are based more on family affiliations and personal connections than merits and qualifications. Perception of Non-Muslim customers In this ongoing global economic recession, the Islamic banking structure is gaining increasing popularity among the non-Muslims across the world due to its broader product services and its ability to stand against the odds of economic recession where many conventional banks are collapsing. The major purpose of Islamic banking system is to manage and distribute finance in the manner that complies with the Islamic laws and principles. The growing popularity of Islamic banks among the non-Muslims is due to its “strict lending principles, reflecting industry efforts to transcend religious beliefs to gain greater market share” (Abdullah et al., 151). The Islamic finance is a combination of Islamic concepts of economics as well as modern lending rules, therefore the banking products of Islamic banks can be convenient both for Muslim and non-Muslim customers. Initially, Islamic banks catered to those Muslims who did not favor the interest system in conventional banks. Gradually, Islamic banks attracted the ultra rich Arabian investors who look for ethical investments. Finally, in this current economic crisis more and more non-Muslim population is looking for less risky ventures since there has been a growing non-reliance on Western approach of financial management. Based on a research conducted on 152 respondents from Kuala Lumpur, Malaysia, Abdullah et al. (2012) have found out that the popular perception is that Islamic banking will control the conventional banking system in Malaysia. This study has revealed that selection of Islamic banks is based more on experience and knowledge of Islamic culture. Likewise, non-Muslims belonging to the age group of 19 – 35 years carry better awareness and knowledge about Islamic economic and finances since various sources of news and information are accessible to them. This means non-Muslim people who are better cognizant about the functioning of Islamic banks will prefer these banks. However, this study cannot be considered as comprehensive since Malaysia being one of the most liberal Muslim countries in the world, the Islamic banks provide almost similar products and services like the conventional banks, and so customer preferences often do not differentiate between the two banking systems. References Abdullah, Abdul Aziz, Sidek, Rokiah & Adnan, Ahmad Azrin “Perception of Non-Muslims Customers towards Islamic Banks in Malaysia”, International Journal of Business and Social Science, 3.11 (2012) 151-163 Alemu, Aye Mengistu “Factors influencing consumers’ financial transactions in Islamic banks compared with conventional banks”, African & Asian Studies, 11.4 (2012) 444-465 Al-Tamimi, Hussein A. Hassan, Lafi, Adel Shehdadah & Md Hamid Uddin “Bank Image in the UAE: Comparing Islamic and Conventional Banking”, Journal of Financial Services Marketing, 14.3 (2009) 232-244 Bacha, Obiyathulla Ismath “The Islamic inter bank money market and a dual banking system: the Malaysian experience”, International Journal of Islamic and Middle Eastern Finance and Management, 1.3 (2008) 210-226 Chaker, Mohammed N. & Jabnoun, Naceur “Barriers to service quality in Islamic banks in Qatar”, International Journal of Commerce and Management, 20.4 (2010) 296-307 Chi, Christina Geng-Qing & Qu, Hailin “Examining the structural relationships of destination image, tourist satisfaction and destination loyalty”, Tourism Management, 29.4 (2008) 624-636 Gobat, Jeanne. “Banks: At the Heart of the Matter”. IMF. n.d. February 18, 2014 from: http://www.imf.org/external/pubs/ft/fandd/basics/bank.htm Read More